Housing is a key sector in any economy and many developed countries pride themselves on a high level of homeownership. Certainly that is the case in Canada and the U.S., and increasingly the case in emerging economies such as China where homeownership has grown very rapidly. But, as we have painfully seen in recent years, over-investment in housing creates fault lines that result in enormous economic instability and dislocation.

Case in point is Spain, where the housing bubble has caused an economic disaster. For nearly a decade starting in 1999, house prices exploded in Spain as both domestic buyers, and more notably, foreign buyers poured money into residential real estate. Europeans, Russians and others were using the Costa del Sol as their vacation hideaway and condo building in all parts of Spain exploded. The return on investments in residential real estate majorly outpaced the return on any other asset class, so even ordinary Spaniards bought second and third homes expecting to rent and flip them for astonishing gains.

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The growth boom in Spain was focused on housing, and households invested a significant portion of their assets in residential real estate. At its peak in 2008, nearly 80% of Spanish household assets were in real estate, well above current levels in the U.S. and Canada. For Canadians, the share (39% in 2011Q4) is close to a record high, at least as far back as 1990 when the data first became available. The Toronto condo boom has raised the spectre of a Spanish-style housing bubble fuelled in large measure by foreign capital and domestic investors — but the numbers so far pale in comparison to what happened in Spain or the U.S.

As the U.S. housing market is bottoming, Spain’s housing collapse likely has much further to go and it is taking the Spanish economy down with it. In Spain, house prices have already fallen 21% from their peak in Q1 2008 and some estimate that they will ultimately be down more than 55% before this is over. This compares to the total decline in U.S. house prices of just under 35%.

Normally, in such a situation, one part of the adjustment process is a devaluation in the domestic currency; but, because of the euro, this adjustment mechanism is not available. Instead, a hugely painful internal devaluation of wages and prices must occur.

The housing bubble in Spain was proportionately 2.5 times bigger than in the U.S. and the decline in the U.S. dollar has helped to offset some of the effect on the U.S. economy as net exports and corporate spending cushioned some of the impact. In Spain, there is no such cushioning, so the economy is in free fall and exacerbating the situation are the draconian fiscal cuts forced on the Spanish government by the stronger countries of Europe. The overall jobless rate has risen to nearly 25% and youth unemployment now exceeds 50%.

In addition, mortgages in Spain, unlike the U.S., are recourse loans so there are no ‘strategic foreclosures’ where homeowners walk away from their homes, but keep the rest of their assets. In Spain, as in Canada, losing your house means losing everything. Even with unemployment at Great Depression levels, homeowners are trying to make their mortgage payments, but many are at risk of losing everything. As well, banks are reluctant to foreclose to avoid further reductions in their already depleted capital. It has been reported that, in some cases, they are reducing monthly payments by converting amortized loans into bullet loans, increasing the risk to the bank.

Most Spanish banks have not fully reported the decline in their asset values. The cost to the government to return their banks to solvency is likely larger than currently recognized. Moreover, Spanish bank exposure to commercial real estate is also relatively high and commercial developers are largely near bankruptcy.

Lessons Learned for Canadians

Too much reliance on housing appreciation for wealth accumulation and retirement security is very dangerous. Retirement nest eggs in Spain have been obliterated, and nest eggs in the U.S. have shrunk considerably. Too much household debt is also very dangerous. It increases vulnerability to interest rate risk and to economic risk of income losses or job losses. Canadians are in much better shape than so many in the rest of the world, but Canadians have taken on far more risk than ever before. As more and more of us depend on RRSPs rather than traditional pensions and will need to rely, as well, on home equity to assure financial security, we are more vulnerable than ever to market swings and economic risk. At a time when more of the population than ever before is running out of runway before retirement, stepped-up saving and significant debt reduction are more important than ever.